One Small Step for Better Monetary-Policy Models

When I spoke at the Federal Reserve Bank of New York on March 1, I pressed hard for less reliance on data that washes away growing U.S. economic-inequality gaps. Happily, many at the talk readily concurred. For those who disagree, take note: an amendment added on March 6 to a House Financial Services Committee budget statement for the first time demands that the Fed do better when it makes judgments about U.S. prosperity.

The Diverse-Data Amendment

The new language comes by way of an amendment offered by Rep. Al Green (D-TX) and approved by the House Financial Services Committee as it finalized its views on the FY19 federal budget. Although most of the House Financial Services’ Committee action on the budget “views” was as partisan as usual in that fractious panel, the Green language was adopted on a bipartisan basis. It states that:

The Committee believes that the mandate of achieving the goal of maximum employment pertains to all communities in the United States. The Federal Reserve is expected to use its resources to achieve maximum employment in all communities for the betterment of our economy as a whole.

This sounds straightforward and perhaps many on the committee thought it was when they approved it after debating whether the initial language mandating “diverse” data meant quotas for minority communities (which Republicans strongly opposed). Even though any mention of diversity was struck in favor of the compromise above, the Green amendment is a push towards recognizing America as it is, not as econometric models have long assumed.

Fed models now are generally “representative-agent” ones – that is, they assume all Americans are pretty much the same so all Fed policy signals transmit efficiently through the economy. This works if enough Americans approximate the “representative agent” selected by the model – indeed, it worked quite well for the decades in which the middle class was the broadest macroeconomic sector with the highest propensity not only to respond to Fed signals, but also to have this make a macroeconomic difference when they did.

That this representative-agent framework isn’t working anymore shouldn’t have taken House intervention. Although the Fed now calculates unemployment at 4.1 percent, which it says is near or a little beyond “full” employment, it also says that African-American unemployment has averaged 7.3 percent and Hispanic unemployment has averaged 5.0 percent since mid-2017. Because the lower down the economic ladder, the greater the odds of uncertain or ill-paid employment, even those in the minority population with jobs are not enjoying the “full” benefits the Fed posits when it congratulates itself on meeting its “maximum employment” mandate. “Gig” employment, contract work, and all too many workers with multiple jobs also mask “maximum” employment across the length and breadth of low-and-moderate income households, race notwithstanding. Indeed, a recent study finds that 7.1 million prime-age men are sitting out the “recovery.” If you’re high-skilled or even better white and high-skilled, employment is indeed “full” and maybe even fulsome; if not, not so much.

Remaking the Model

Because the Green language is only an amendment to budgetary views, it is in no way binding. It also may or may not make it into the final budget resolution that then may guide Congress in the event – unlikely these days – that U.S. fiscal policy follows regular order. But enacted or not, the Green amendment is an important warning about the political consequences of continuing monetary-policy mistakes. The Fed should quickly take heed.